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Steel Dynamics: Impossible to Ignore China

Bridget Freas, CFA

Bridget Freas: I'm Bridget Freas with Morningstar. Joining me from Steel Dynamics is Dick Teets; executive vice president and COO for steelmaking. He is also one of the founders of the company less than 20 years ago, making Steel Dynamics one of the relative newcomers to the U.S. steel industry and it's grown to be one of the larger steel companies and metals recyclers in the U.S.

Dick, thanks for being here.

Dick Teets: Good morning. Thank you.

Freas: I would like to start off talking about the selling price of steel, which has been very volatile in the last few years, particularly for flat-rolled. Now, some of that volatility can be explained by the high cost of raw materials, iron ore, and scrap, but I'm wondering do you think there is anything else that's driving the shortened price cycles, and what has Steel Dynamics been doing to maximize profitability when your selling prices change so quickly?

Teets: I think some of the other influencing factors in the changing steel prices, from a sales perspective, are inventory levels and bank credit availability of the customers that buy from us and would normally carry inventories. Also the, I call it, panic-buying mode sometimes happens when people are watching the cycles because they have such short inventory cycles. When their inventories become maybe distressingly low, they have to go out and quickly buy and hope that it is at the bottom of the cycle. And when the prices start to rise, then all of a sudden the orders flow in.

I think the things that we do a little bit differently are that, number one, we understand it and we don't react in a manner that some of our competitors do because with our variable cost structure, our low cost structure, we can weather the storm better when our backlogs are shorter and so forth than we'd like. But needless to say, some of our competitors with fixed costs and large requirements to feed blast furnaces and basic oxygen furnaces have to go out and react a little bit differently, and we can sort of ignore that panic at the time.

Freas: Yeah, and you mentioned the cost structure. I think one of the things that has really stood out during the recession is how much profitability depends on your raw-materials cost base given that steel prices and raw-materials prices no longer move so closely in tandem. Steel Dynamics has made a number of initiatives on this front, first with Iron Dynamics, then the purchase of OmniSource, and now more recently with Mesabi Nugget. How do you think these things have changed the competitive environment? Do you feel that they give the company a leg up, or do you think these types of initiatives are becoming a must-have for any steel company to effectively compete?

Teets: Well, I don't know that it's a must-have, though many of our competitors have also started ventures not in as many different areas as we have but on a limited basis. I think it gives you a very strategic benefit whereas we're now involved in the scrap business. The scrap company that we own is OmniSource, and it supplies about 45% of what we consume, and we only buy maybe 43% of what it produces. So, it gives us a great opportunity. We're still out there in the market.

We're paying market prices, but it has afforded us, just like those customers I referred to in the first answer with lower inventory levels, it has allowed us to take our inventories down ahead of the mills. So, therefore, we benefit from that involvement. Mesabi Nugget and Iron Dynamics are both great projects that take us out of the scrap markets from that equivalency standpoint. We continue to invest, and we'll continue to invest in that backward integration.

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Freas: Now, I'm wondering looking ahead at 2012, what role do you think that China is going to play? We first heard about orders weakening in Europe. Now, the focus seems to be on China and the potential for a slowdown in steel consumption there. Meanwhile in the U.S., perhaps demand hasn’t been as strong as we would like to see, but it's certainly trending better than in other parts of the world.

So, for a company like Steel Dynamics that mainly serves the U.S., what happens if we see a big slowdown in China? Might it try to ship more products here, or do you think we'll see some easing in raw-materials costs given that the growth of China had really pushed those costs so high and now appears to be faltering? How do you think about China?

Teets: Well, I think you're right on, especially in the end with the raw-materials cost, that as the Chinese production slows down, there is definitely a market reaction to that on the raw-materials side because so much of the country's buys are in the spot market. So, therefore coal costs, iron ore costs, and the like will moderate. That also has an influence on what we're doing especially in our scrap-substitute facilities, but I think also think that, needless to say, we have to be alert to what China does.

We bring trade actions whenever it's appropriate, ourselves individually or in concert with like-minded competitors. I think that China also is slowly learning about leaving market forces. I mean, I'm not trying to tell you that's perfect, but I think between export rebates and taxes and so forth, the county has made, I think, some improvements in those positions which causes those steelmakers to slow down, whereas before it was allowed to just continue to produce whatever it wanted to, and let the exports just be the buffer. I think that's been reined in a little bit, but China is a dynamic that can't be ignored.

Freas: Finally, I think when people think about steel, they think of the construction markets, but there really hasn't been much just to speak of in the last few years with nonresidential construction activities still down 50% or 60% from the activity levels of 2007. How has Steel Dynamics adjusted to this, and do you think we're going to need to see a full recovery in the construction markets in order to regain the profitability levels of the years leading up to the recession?

Teets: Well, the years leading up to the recession were amazing years from a profitability standpoint. I won't tell you that they can't be re-created, but I don't believe it's going to be on the back of nonresidential construction. I think really it has to be infrastructure. I think we have recognized that there was just a perfect storm of credit, development, and so forth in nonresidential construction, but that has created such a glut in some of those marketplaces that it'll be quite a few years until there is really a great recovery.

We, recognizing that, have really spent our time developing alternative products to be produced in our mills, at our structural mill in Columbia City, Ind., where it was almost 99% structural at the time of the prerecession. We now are producing railroad rail. We're producing other channels or other non-parallel-flanged products, and I think the recovery will be to those who recognize the need for new products and opportunities to take advantage of them.

Freas: Well, I look forward to seeing better things for Steel Dynamics in the years to come. Dick, thanks for being here.

Teets: Thank you very much, Bridget.